The stock market is fixated on interest rates and inflation, hoping a decline in the latter will bring a fall in the former. The problem is that this would mean lower profits than currently expected.
Though it has been rallying this week, the S&P 500 remains about 18% below its January 2022 record high. The main factor is that high inflation has prompted the Federal Reserve to lift interest rates in order to reduce demand for goods and services and keep prices from rising even more. An end to rate increases would allow investors to look ahead to the end of the economic damage they bring.
In the past month, the stock market’s inverse correlation to interest rates, themselves driven in part by expectations for inflation, has been extreme, with the S&P 500 repeatedly rising in line with declines in real yields on 10-year Treasury debt.
According to Morgan Stanley data, over the past month, the correlation between gains in the index and the 10-year yield minus the expected annual inflation rate for the next decade has been minus 0.5%. To put that in context, since April 2021, the figure has ranged from 0.5%, with stocks rising despite higher yields, to -0.8%.
But there is a problem with investors pinning their hopes on declines in inflation. Doing so “ignores the ramifications of falling prices on profit margins, which is likely to outweigh any benefit from the perceived Fed dovishness equity investors are dreaming about later this year,” wrote Mike Wilson, Morgan Stanley’s chief U.S. equity strategist.
Lower inflation would mean smaller price increases—a negative for companies’ sales. And don’t forget: The Fed is trying to rein in price increases by cutting into demand, so the quantity of goods sold may well have declined by the time inflation is significantly lower.
Reduced sales would probably weigh on profit margins. Many companies have some fixed costs, so lower sales make businesses less profitable even if companies pull back on headcount and marketing expenses.
The S&P 500’s aggregate operating margin for 2022 is expected to turn out to have been about 16.7%, according to FactSet. That is down a smidgen from 16.9% in 2021, when companies began aggressively raising prices, but it could fall further. In 2019, before the pandemic, the index’s operating margin was 15.5%.
Lower margins plus lower sales imply an ugly drop in earnings, indicating that analysts are likely to keep lowering their forecasts for profits. Stock prices would have to fall unless investors are willing to pay more now for each dollar of future earnings.
So while the stock market is looking far ahead, to when inflation is lower and the economy has recovered from the higher rates needed to achieve that, the shock of getting there may be bigger than investors expect now.